The Independent Investor: Why Are Interest Rates Rising?

Bill Schmick04:56PM / Thursday December 16, 2010

U.S. Treasury bond interest rates are rising. Since August, the yield on the 30-year bond has risen over one percent, the 10-year is up 118 basis points and the five year is up 102 basis points. For those unfamiliar with the government bond market these are moves akin to the stock market rising 50 percent.

It wasn't supposed to happen this way. The Federal Reserve Bank's second quantitative easing (QEII) was meant to keep interest rates low, provide even more liquidity to the markets and, hopefully, convince banks to lend more to cash-strapped consumers — or so we thought. The opposite appears to be happening.

This is a positive development in my opinion. Here's why:

When an economy moves out of recession and into recovery, one of the first things that happens is interest rates begin to rise. This occurs for a variety of reasons. Investors, for example, are willing to take on more risk. During recessions (including this one) investors normally keep their money in safe investments such as U.S. Treasury bonds. As the data indicates that the economy is beginning to grow again (as it is now), investors sell their bonds and buy stocks as they take on more risk and look for higher rates of return.

Bondholders also worry about the potential for inflation as the economy heats up. There is a lot of historical evidence that inflation begins to rise as the economy grows. Bond prices usually decline and yields rise to compensate for that expected increase in inflation. The point is, that after months of worrying whether the economy will fall back into recession or simply bump along the bottom, this rise in U.S. Treasury bond yields is living proof that the economy is finally growing again and at a rate that convinces investors to sell their bonds and buy stocks.

Now not all bonds should be sold simply because interest rates on Treasury bonds are moving higher. Rising rates are actually a positive for a wide variety of bond investments such as corporate and high yield corporate bonds (called junk bonds). Many of these bonds actually do quite well. That's because with economic-growth investors are more confident that these corporate-bond issuers will be able to service their interest payments and actually pay off their debts. Investors actually see the price of these bond issues move higher.

There is also a supply and demand explanation for rising yields. During the last two years an enormous number of investors have fled to the safety of U.S. Treasuries. Suffering steep losses in the stock market because of the financial crisis, trillions of dollars were invested in Treasuries with no regard to the rate of return on these bonds. Now that the clouds are lifting and the coast is a bit clearer, these same investors are beginning to cash out of bonds. The problem is that everyone is heading for the exit door at the same time.

This year, when the rumors of a possible QE II started to surface, aggressive traders jumped into the Treasury markets with both feet. By the end of August, according to Greenwich & Associates, hedge funds accounted for 20 percent (versus 3 percent in 2009) of the daily trading volume in the $10 trillion U.S. Government Bond market. Following them in were armies of speculators, both here and abroad, all eager to "buy the rumor" of another monetary expansion by the Fed.

Now that QE II has occurred, we are experiencing a classic "sell on the news" exodus from that market at the same time that longer-term bond investors are also selling. This provides a simple explanation for the truly astounding 44.75 percent jump in yields that have occurred in just over two months.

Bill Schmick is an independent investor with Berkshire Money Management. (See "About" for more information.) None of the information presented in any of these articles is intended to be and should not be construed as an endorsement of BMM or a solicitation to become a client of BMM. The reader should not assume that any strategies, or specific investments discussed are employed, bought, sold or held by BMM. Direct your inquiries to Bill at 1-888-232-6072 (toll free) or e-mail him at wschmick@fairpoint.net. Visit www.afewdollarsmore.com for more of Bill's insights.

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